Trading constraints with unspecified constraint horizon are imposed on the shares held by the state in the IPO of each listed firm in China Stock Market. In 2005, a so-called Split Share Structure Reform (also known as Division Reform) was launched in which the holders of restricted shares give up a proportion of their shares to purchase the right to terminate the trading constraint. From the size of the compensation, we infer the value of restricted shares and find that their price discounts are negatively affected by the restriction looseness captured by our proposed new multi-dimensional measure and positively affected by the bargaining power of the holders of freely-traded shares.

Imposed trading constraints act as an exogenous source of illiquidity, prevent free trading of restricted shares and make them be priced at a discount relative to their freely-traded counterparts with identical dividends and voting rights from the same listed firms. This paper numerically solves the theoretical illiquidity discounts for the case of long constraint horizons and then reconciles the contradictions in the results of various frameworks by identifying the effects of the unlimited and costless borrowings assumed in Longstaff (2001). With control of leveraged positions, illiquidity discounts increase with the volatility, and their size is greatly diminished. We also empirically test the theories within the unique setting of China, which has virtually the largest population of restricted shares worldwide. Large discounts are documented in two forms of transactions in restricted shares: namely auctions and transfers. The results empirically verify the theoretical findings by showing that illiquidity discounts in auctions increase with both the volatility and constraint horizons. The results from transfers, however, are not significant as the transfers are made privately and may be subject to price manipulation when the involved parties are related.